U.S. Swap Spread Narrowest on Record on Fed Rate Speculation

U.S. interest-rate swap spreads plunged to the narrowest on record as traders speculate the Federal Reserve may reduce how much it pays on reserves at today’s policy meeting to keep money market rates low.

The difference between the two-year swap rate and the comparable-maturity Treasury note yield, known as the swap spread, dropped to as low as 5 basis points, according to Bloomberg data compiled since 1988. The gap, in part a gauge of investors’ perceptions of U.S. banking-sector credit risk, is derived from expectations for the dollar London interbank offered rate and the direction of short-term government debt yields. The spread was as much as 24.6 basis points on June 24.

Fed officials have cited cutting the interest paid to banks on excess reserves, known as the IOER, as a method that could be used to convince investors that tapering its bond purchases isn’t the same as tightening monetary policy. Lowering the rate, now at 0.25 percent, is among “ideas that are still in play” as the central bank seeks to improve the way it communicates the outlook for interest rates, Atlanta Fed President Dennis Lockhart said on Dec. 5.

“Speculation the Fed may take steps that lower money market rates today has in part caused the swap spread to narrow,” said Boris Rjavinski, U.S. interest-rate derivatives strategist in Stamford, Connecticut, at primary dealer UBS AG. “As the U.S. economic data began to improve over a month ago, some investors put on Eurodollar futures positions wagering on higher money market rates in 2015-2016. The two-year swap spread narrowing has hurt these trades, causing some leveraged accounts to liquidate positions, which is feeding on itself and has caused further spread narrowing.”

Taper Expectations

Eurodollar futures are settled at expiration to the three-month dollar Libor rate. Three-month Libor is 0.24510 percent, up from 0.24435 percent yesterday, according to the British Bankers’ Association.

Giving a 60 percent chance that the Fed reduces debt purchases as soon as today, Pacific Investment Management Co. Chief Executive Officer Mohamed El-Erian said yesterday in a Bloomberg Television interview that such action may also include a cut in what the Fed pays banks for excess reserves or other steps to shore up its forward guidance on policy rates.

Policy makers will maintain purchases at $85 billion a month at the conclusion of their two-day policy meeting today, according to a Bloomberg News survey of economists. The Fed has kept its benchmark rate, the target for overnight loans between banks, at almost zero for five years.

Swap Rates

Swap rates have traditionally been higher than Treasury yields in part because the floating payments are based on interest rates that contain credit risk, such as Libor. Swap rates serve as benchmarks for many types of debt often purchased with borrowed money, including mortgage-backed securities and auto-loan securities.

The debate on an IOER cut was revived when the Fed began testing the use of reverse repurchase agreements with Treasuries in September to give policy makers greater control over short-term borrowing costs. The daily draining of funds through the tests has helped lift the rate to borrow and lend Treasuries for one day in the repurchase agreement market.

Cutting the IOER, which is unlikely at this week’s meeting, “would lower the overall structure of rates at the short end, which might lead to negative rates for short bills, overnight repurchase agreement rates and even overnight Eurodollar deposits,” Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, wrote in a note to clients published on Dec. 16. “For the first time, there now a potential benefit to cutting the IOER. FOMC members view the move as symbolic rather than substantive, but the symbolism could be useful if the Fed is concerned about the market response to the first cutback in asset purchases.”

Repo Rates

The average rate for borrowing and lending Treasuries for one day in the repo market was 0.092 percent yesterday, up from as low this year as 0.016 percent on May 29, according to the DTCC GCF Treasury Repo index.

The yield on the benchmark U.S. two-year Treasury note rose two basis points to 0.34 percent. A $32 billion auction of two-year notes yesterday drew the strongest demand in 11 months.

Two-year “swap spreads tightened significantly and made new lows for the year as cash was parked at the front-end and Eurodollar contracts rallied strongly,” wrote Richard Gilhooly, an interest-rate strategist at TD Securities Inc. in New York, in a note to clients yesterday.

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